Brian McMorris - New Year Financial Outlook - 2006

8/14/2019 Brian McMorris - New Year Financial Outlook - 2006

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To All My Investor Friends: Happy New Year 2006

It is hard to believe another year has gone by so quickly. Where does the

time go? It was a challenging year for investors. The markets went down,

they went up, and ended up not far from where they started. One had to be in

the right place at the right time to make any advance in 2005. I was

fortunate to do just that with a market beating portfolio again this year,

for the 7th year in a row (since my dismal relative performance in 1998).

This year saw the launching of my financial services website: www.wealth-

ed.com. It also saw my enrollment in UCLA and their online Financial

Planning certificate program. I received As in both classes I took (I am

sure you are impressed), and had great enjoyment in the curriculum and my

return as a university student for the first time since 1982. But as the

year progressed, I found the time is not right to make Financial Planning a

full time, or even part time endeavor. Instead, I am assisting my son,

Jared, with his own business and website: www.xactsensing.com. I will get

back to the financial services business once XACT is up and running

profitably. Still, I will continue to post this annual letter, plus the

occasional financial or life insight on Wealth-Ed (The Money Academy).

As always, I start by recounting last years plan (quotes in italics as

emailed on Dec. 31, 2005) and how it fared:

My overview of the market to you at the beginning of 2005:

The story line for investing in 2005 has one important theme: Protect

against a declining dollar.

Okay, this goes to show that one cant count on being right all the time. I

was dead wrong on the direction of the dollar vis--vis other currencies.

However, I was not wrong about the underlying weakness of the USA currency

due to current account and budget deficits and the direction of gold and oilagainst the dollar. But what I didnt count on was the commitment of other

central banks to match the dollar move for move. Basically, we are in

another period of Beggar thy neighbor. This is an economic concept whereby

each country tries to devalue its currency against others to improve its

domestic economic agenda, i.e. to put its people to work. The last time the

world saw a prolonged period of this phenomena was the 1930s. Need I say

more?

I have been concerned about the rate of appreciation in real estate since at

least 2002. 10% plus appreciation is not sustainable for any length of time

since real estate historically appreciates at the rate of inflation plus 1%(probably attributable to quality-of-life improvements like average square

feet, plumbing, water and electricity) and no more. Here was my comment last

year on that subject:

We are currently at a flux-point after the bursting of one bubble, the stock

or equity bubble, but just prior to the bursting of a real estate bubble. We

can argue about the degree of the real estate bubble, but not about its

existence. The long term, 100 year average of real estate appreciation is

approximately the same as real GNP (inflation adjusted). So, in this period

of low inflation, there should also be low real estate appreciation on par

with GNP, about 3-4% annually. Yet, real estate has been appreciating from
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10-20% annually in various markets the past 10 years. This is a bubble and

it must burst or revert to historical norms at some point.

First, Dr. Robert Shiller (Yale University) precisely defined growth at 1%

over inflation, the number I now reference, in his book from March 2005,

Irrational Exuberance 2. This number was arrived at by extensive

historical research conducted by a squad of graduate students. So, long

term, 100 year growth rates in real estate are less than I had estimated last

year (3-4% over inflation). Second, I believe government and industry data

from the last couple months (nearly 20 year high in housing inventory on the

market, days on market at over 60 days, another 20 year high), shows that

the real estate bubble is in the process of being popped, thanks in large

part to the commitment of the Fed to raise interest rates and discourage

excess lending. We will know more next year at this time how severely the

real estate markets turn down, which geographic markets are most affected and

whether all of this precipitates a recession.

On my list last year of 10 things to consider for financial security, number9 was:

The very best commodity to hold in 2005 will be gold. Why? Gold is thelikely exchange currency of choice should the $USD fall out of favor because

of the devaluation underway. Also, gold is a commodity that has many

industrial uses and is therefore consumed every year. It is relatively

difficult to increase supply, so a suddenly increased demand is likely to

exceed the ability to increase supplies to match.

Again, I was right on the money here, and my position in gold stocks

benefited because of this call. I believe this trend will continue for some

time. It has only just started. The gold cycle is similar to the oil cycle.

They benefit from both being valued as hard assets with intrinsic historic

value, even though the values are different to homo sapiens. As our trade

and budget deficits continue to weaken the dollar, it becomes less attractive

as the worlds reserve currency and gold becomes more attractive. This

change in thinking will take years to play out as gold continues its march to

$2000 per ounce.

Here is my advice from 2005 and my commentary on any changes needed for 2006:

+ Stay conservative (Still True and will be until equities are again

cheapbelow 10x current earnings); I still think this is not a time for the

market to rally. The market price to earnings ratio is not anywhere near a

typical low in respect to valuation, at the current 17 or 18 times (even

higher once employee stock option expenses are deducted from earnings, which

will be required by July 1, 2006). But a 10x earnings factor would require a

significant inflationary environment. I am not as convinced of runaway

inflation as last year, especially with Ben Bernanke as Fed Chairman. So I

am changing the definition of a cheap stock market to 13 times in a 5%inflation environment.

+ Protect against the possibility of inflation inflation is very likely in

2005, more so than 2004 for reasons that will be outlined. While inflation,

as measured by CPI, stayed relatively quiet in 2004 at less than 3%, it

reversed 20 years of downward direction; given the large increases in

commodity prices, most notably oil from $25 to $50 per barrel, inflation will

continue to accelerate into 2005. How do you like that prediction of $50

oil? Seemed crazy a year ago when at $35, didnt it? This is why I think


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that 5% inflation is baked into the cake, even though government stats dont

yet report it. Commodities of all kinds have increased 2-5 times over what

they were in 2000 (when oil was $10 for a time). Much of this is offset by

imports of cheaper manufactured goods from Asia. But going forward, imports

will not get any cheaper (higher commodity input prices and increasingly

higher labor costs are also a reality in China) and the higher costs of

commodities will work their way through the world economy.

+ Sell REITs and any commercial real estate holdings; we are at the peak of

a 20+ year real estate cycle; REITs are now selling at prices that yield less

than 5% on average, on par with risk free 10 year Treasuries; REITs will be

hurt by higher interest rates and an eventual economic downturn in 2006.

Cash out now; Hey, another good call! I havent changed my views on real

estate, and wont until we get those REIT dividend yields back to 8% like

they were in 1999 and 2000. All that is required is for real estate to

decline relative to other asset classes and rents / revenues to increase.

This will not happen for another 5 or more years. REIT yields are now less

than super-safe 6 month T-Bills.

+ Stocks: the Large Cap Value sector is the last stop during a business

cycle. This was a good strategy in 2004 with a total (price + dividend)return on the Russell LC Value 1000 (ETF ticker: IWD) of 14.2%. High

dividend, high ROE and free cash flow, large cap, and slow growth stocks will

do well again in 2005; medical, insurance, energy, consumer staples

(household) products, defense, are the place to be at the cycle peak and

going into a business downturn (in 2005); expect another 10-20% return in

2005 on this sector; Okay, this one wasnt perfect, but not bad either.

Classic recession proof / defensive sectors like consumer stales and defense

did not do well because the economy held up well against all odds. But

defensive energy and healthcare proved to be very good sectors for 2005,

placing first and third out of the ten S&P sectors (utilities, another

defensive sector was No. 2). I wouldnt make any changes to this prediction,

since I think we will finally see the economy weaken in 2006, though I have

lowered my energy exposure since it has become fully valued at this time.

Utilities, which I never bought, are also fully valued.

+ Commodities: given the direction of the dollar, a very good hedge is to own

commodities which will appreciate in $USD terms, as the dollar declines. The

best way to own commodities is mutual funds or ETFs that hold companies

producing those commodities. Additionally, many have significant dividends.

See the following for recommendations. This was perhaps my boldest and best

call. Gold mining stocks increased over 40% in 2005 after years of doing

nothing. All the commodities did well in 2005, especially the first half.

We are in a bit of a pullback in most commodities as they have become over-

owned, but I think this is a significant long term trend and will add to my

positions on price weakness.

+ U.S. Bonds: because inflation is accelerating, stay very short term inbonds: less than 3 year duration on average and preferably Inflation-

protected; Hi-yield or junk bonds are at cyclical high prices and will only

go down, especially with increasing defaults at the next economic downturn;

wait for the next recession to rebuild junk bond positions; This was the

proper recommendation for 2005, though the long bonds did not get hammered as

expected. So anyone who did not shorten duration or improve quality got a

break. Given the economic environment and the flatness of the yield curve as

of this date (January 2, 2006), in 12 months, either long bonds will be at 5%

and maybe much more, or we will be in a recession, at which point, short term


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rates will be on their way down. Neither scenario is good for high risk

bonds. Stay short.

+ International: Continue to invest in overseas funds and stocks that are not

hedged for the U.S. currency. Because of trade imbalances, the dollar

decline will continue. A simple way to protect against a declining dollar is

the purchase of unhedged international funds; this is another good strategy

that has paid off big time for me. I have particularly liked Asian stock

markets that are benefited by the Chinese economic juggernaut. The dollar

situation did not work, as earlier noted, so there was not a boost from

exchange rate changes. But even with a strengthening dollar, the Asian

markets had a very good year. My ETFs in Korea (EWY, 53.89%) and Japan (EWJ,

24.34%) were especially rewarding. This is a good time to sell half of my

Asian stocks to take profits and protect against a sell-off, but keep half

for continued exposure to the worlds best growth market for the next 20

years. And I still believe the dollar will eventually devalue against other

currencies, so that stock price boost is yet to come.

PORTFOLIO PERFORMANCE AGAINST BENCHMARKS:

This year I am adding a historical summary of my personal portfolioperformance against two benchmarks, the Fidelity Freedom Fund 2020 (FFFDX, an

asset allocation fund designed for people like me, who will retire around the

year 2020) and the Fidelity Spartan S&P 500 index fund (FSMKX). Really a

balanced portfolio, with its lower risk bonds and cash should logically

under-perform an equity-only portfolio like the S&P500, but I still aim to

beat the stock market with my lower risk asset-diversified portfolio, by

making correct asset allocation decisions. Here are the past eight year

results. Note the disaster in 1998. The lesson learned there is not to have

most of ones financial assets in one stock, my employer STI in this case

(folks at Enron and MCI learned the same lesson in 2002):

1998 1999 2000 2001 2002 2003 2004 2005

McMorris 27.2 31.9 0.5 1.6 4.1 26.9 14.1 14.7

FFFDX 21.7 25.3 3.0 9.1 13.7 24.9 9.6 6.3

FSMKX 28.5 20.7 9.1 12.1 22.2 28.5 10.7 4.8

OVERVIEW of 2006:

To summarize the theme for 2006: it is all about Bernanke. The big change

this year will be what the new Fed Chairman decides to do with the Federal

Funds overnight rate. Alan Greenspan, who has presided over the Federal

Reserve Bank and Open Market Committee as Chairman since 1987, has shown

himself to be adept at blowing bubbles, namely financial asset bubbles. He

has been a politicians favorite kind of central banker: always riding in tosave the economy at the last minute, thereby saving the politicians job.

This happened several times the past 18 years, the first time being October

1987, but then again in 1991, 1995, 1997, 1999, 2001 and 2003 (see the

pattern?!). Each time, on the brink of a crisis (S&L collapse, Asian flu,

New Millenium, 9/11, Iraq war), Greenspan would infuse the economy with

liquidity (cheap money) to inspire the spending behavior of the consumer and

businessman, who otherwise might pull in their financial horns and go stuff a

mattress.


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another big change with Bernanke; he has said he will be very concise and

clear about his policy direction and will publicly state his targets.

What will be the effect of changing the central bank focus from interest

rates to inflation? The first conclusion that can be made with near

certainty is interest rates will gradually drift higher, so long as the

economy is strong and supply is tight for global commodities. Bernanke will

be very interested in balancing supply and demand through interest rates to

achieve the inflation target. If the labor market tightens because of the

strong economy, if the GNP exceeds 3.5% growth (the widely accepted

equilibrium rate) and if pricing power increases because aggregate demand

exceeds supply, Bernanke will not hesitate to increase Fed Funds rates.

I believe that Bernanke disagrees with Greenspans bubble blowing policies.

He will take the current opportunity of increasing interest rates to continue

taking air out of the real estate market. He will not stop until a shallow

recession is achieved. Indications are that Bernanke will not be as

concerned about appeasing Washington as was Greenspan and will not hesitate

to apply the brakes on economic expansion. Because the past growth cycle has

been fueled by consumers using housing equity to finance purchases, to the

point of achieving a negative savings rate in this country the past threeyears, he will seek to shut down this debt produced expansion. Once the

shallow recession has been achieved and consumer debt expansion is halted by

higher interest rates along with a weaker economy, Bernanke will reduce Fed

Funds rates to a level that encourages business spending on capital goods,

without reigniting the housing bubble.

How bad is the consumer debt fueled expansion in a historic context. Here is

a chart of government data on the average savings rate for Americans showing

the rate going negative in 2005 for the very first time:

Personal Savings Rate vs. 10 Yr. Treasury(data from St. Louis Federal Reserve)

-1.00

1.00

3.00

5.00

7.00

9.00

11.00

13.00

Jan-59

Jan-62

Jan-65

Jan-68

Jan-71

Jan-74

Jan-77

Jan-80

Jan-83

Jan-86

Jan-89

Jan-92

Jan-95

Jan-98

Jan-01

Jan-04

Chart by "Money Academy"

10 Yr. Treasury Rate

Personal Savings Rate

This is then the 2006 scenario: an economy that gradually weakens through the

first half of the year while short term rates continue to rise to the 5%-6%

range, resulting in a shallow recession beginning in the 3rd quarter. By the


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4th quarter, the recession will be fully recognized and it is likely that rate

increases will be halted, and depending on the severity of the recession,

even lowered.

If this scenario is accurate, the correct investment posture is to hold a

high percentage of cash and short term bonds, at least 50% of the portfolio,

and maintain defensive equity positions in consumer staples, energy,

utilities, and other deep value sectors. Once the recession is acknowledged

in the media, and perhaps by the Fed, that will be the time to get aggressive

with equity and move to a much higher percentage.

I believe that the next economic cycle will be a capital goods-led cycle. It

has been six years since the last capital goods cycle. Those goods are now

fully depreciated and in the case of technology equipment, obsolete. Because

the end of the recession will coincide with the Presidential cycle, it is

likely there will be tax incentives passed by Congress to stimulate business

spending at the end of the next recession.

If the market retreats to SP500 (900) and/or DJI (8500), it will signal a

great buying opportunity and perhaps the bottoming of the current trading

range we have experienced since 2000. This could set up an end to the Bearcycle and the beginning of a new secular Bull cycle, though I would not be

surprised to see sideways financial markets for another 7-8 years based on

historic patterns. Technology often leads the way out of secular bear

markets (as in 1982) and it may do so again the next time.

See the following chart that I update every year for an indication of the

possible shape of the market over the next several years. History repeats in

investing as well as other human endeavors. So history is prologue to what

will happen in the stock market. This chart presents three significant

periods in the USA stock markets. The 1920s and 30s, punctuated by the Great

Depression, the late 1960s to the early 1980s with the Oil Crisis in 73/74

and the high inflation of the late 70s and early 80s, overlaying the current

market and the blowoff of the Tech bubble in 2000-02. The major elements of

each period are almost identical in amplitude and duration. As with any

physical upset, there is first wild gyration followed by a significant period

of stabilization, followed by another gradual upward period (starting slowly,

and then accelerating into another frothy period 20 years out). The chart

shows we are ending the stabilization period and heading towards a possible

long-term upward period starting between 2007 and 2010.


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10

100

1000

10000

Dow Ind 1925-1940

Dow / NASDAQ 1967-1982

NASDAQ COMP 1995-2010

Secondary Market

Decline (pos t election)

37-38, 76-77

Jul 1924

Jan 1967

Jan 1995

Jul 1934

Jan 1977

Jan 2005

Jul 1929

Jan 1972

Jan 2000Chart by "Money Academy

Primary Market Decline

(post election) 73-74,

30-32

2006 brings

secondary correctionfollow ed by new Bull?

What happened to the USA stock market in 2005 and where does it go from here?

Another chart I use to show historical trends is focused on the idea of

Channels. Market trends tend to move within a channel on either side of a

trend line representing a price average over a period of time. The trend

line and its associated channel only change slope at significant events

during time, such as the Great Depression or the Oil Crisis. This marketanalysis shows we are in a flat trend coming off the Tech bubble blowoff. We

are bound in a channel that is roughly 7,500 on the downside and 11,000 on

the upside of the Dow Industrial (DJI) index.

For the market to advance out of this channel, i.e. change the trend slope

back to an upward trend, it will require a retest of the bottom of the

range. Technical analysis suggests we must retest 7500 DJI, if this indeed

is the lower limit of the channel, reached last in early 2003. It would be

very bold to predict such a precise target, so I am suggesting that anything

approaching 8500 DJI will constitute a retest and will allow the market to

move on up out of the trend channel. If my Bernanke thesis is correct, he

will precipitate a recession that will allow the market to decline to this

range. Note the Pink arrows show the long term trends from previous market

periods. We can expect the market to progress off the bottom following this

trend line and eventually break out of the 11,000 top boundaries by 2010.


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100

1000

10000

100000

Jan-67

Jan-72

Jan-77

Jan-82

Jan-87

Jan-92

Jan-97

Jan-02

Jan-07

Jan-12

Dow Ind 30

Real GNP

- Red channels show

long term t rends.

- Blue arrows showaverage slope o f

major bull market and

acceleration to the

late 1990s bubble.

- Pink arrows show

long term slope of

GNP gro wth and

sustainable market

slope.

- USA Stoc k Market

in 2004 is trending

sideways. If it breaks

the lower side of

M ajor Bull channel in

2005, it is likely to test

the lower limit o f a

multi-year horizontal

channel at Dow 7500

Another chart used here in the past is the Presidential Cycle chart. It is

very instructive primarily because of the power that presidential politics

has in the economy. The President, through Congress, is able to have very

positive or negative effects on the economy through taxation and spending

policy.

Compare the History Repeats chart with the chart of the Dow 30 average for

the past (18) Pre-Election periods. It shows the benefit that is derived

from positive efforts by the incumbent government to stimulate the economy.

This average picture of the market is also identical to both the pattern and

size of the past actual 18 months in terms of appreciation of the Dow 30

averages:


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Dow 30 Performance -

Average of past (18) Pre-Presidential Elections

0.00%

5.00%

10.00%

15.00%

20.00%

1 3 5 7 9 11 13 15 17

Months Chart by McMorris F.P.

We are currently at a flux-point after the bursting of one bubble, the stock

or equity bubble, but just starting to burst the housing real estate bubble.

We can argue about the degree of the real estate bubble, but not about its

existence. The long term, 100 year average of real estate appreciation is

approximately the same as real GNP (inflation adjusted). So, in this period

of low inflation, there should also be low real estate appreciation on par

with inflation plus 1% annually, or around 3-4%. Yet, real estate has been

appreciating from 10-20% annually in various markets the past 10 years. This

is the definition of a bubble and it must burst or revert to historical norms

at some point.

Note the yellow circles on the History Repeats chart. The circles are the

one year periods after a Presidential election (1933, 1977 and 2005).

Typically the year after an election has flat returns. My analysis of 18

past post election periods and the 18 months following the election shows the

average annual Dow Industrial return to be +0.72% during that period. The

actual total return in 2005 of the Dow Jones Industrial average was +2.47%with almost all of this return was in dividends. Price return was almost

exactly the historical average for 12 months after the election. We are now

at Month 13 after the last election (using January inauguration as the

reference). Month 13 to 18 are between 1 and 2 percent growth on average.

But given the continuing recovery off the 2000 tech bust, the market is

currently weaker than average, so a decline is likely.


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Dow 30 Average -

(18) Post Presidential Elections

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

1 3 5 7 9 11 13 15 17

Months Chart by McMorris FP

Another negative in the market is that we are now past the average age of a

cyclical bull market (30 months according to InvesTech research) as of April

2005, we are living on borrowed time before the next cyclical bear.

My approach for 2006

Based on the above historical and current events analysis here is my game

plan for 2006: A range of 8500 to 11,500 for the DOW (just about the same as

2005 and the third year in a row for this forecast range), 900 to 1500 for

the S&P500, 1800 to 2500 for the NASDAQ Composite. I think that the weakness

this year will come in the first half of the year with a bottom during the

summer coinciding with acknowledgement of the mild recession brought on by

short term rates between 5% and 6%. After that, the pre-election fiscal

stimulus, and the end of interest rate increases coming into sight, will

cause a market rally during the fall and early winter, culminating in a

significant Santa Claus rally which went missing this past year (2005).

Asset Allocation:

Asset allocation / diversification, along with identifying the best sectors

and skewing the portfolio to those sectors are the key to financial success.

I learned this lesson in 1997 and 1998 as my relative performance showed. I

badly under-performed the late 90s market by having my eggs in too few

baskets (too much STI company stock) and also being overweight the wrong

sectors (commodities, value and REITs before their time).

Here is my relatively conservative base asset mix: 60% stock, 20% bonds,

10% real estate (excluding our home), 10% cash. In 2005, I changed this mix

for the first time in seven years by decreasing bonds to 0%, reducing the

overpriced real estate segment to near 0%, increasing cash or stable valuemoney market funds to 40%, and maintaining most of the 60% equity weighting

in energy, international and small cap value.

Towards the end of the year, I reduced the energy overweight from 30% of my

overall portfolio (half of equity) to around 15% and increased technology,

which will lead the market after the next correction. All year I have

maintained a relatively heavy 15% of my overall portfolio (30% of equity) in

international stocks, especially Pacific-Asia and Japan.


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At the top of an interest rate cycle, I would normally adjust the allocation

to overweight bonds, REITs and other interest sensitive investments, and

underweight commodities and hard assets that are inflation plays. But I

believe we are in an inflationary environment for the next several years,

cheap manufactured imports and job outsourcing notwithstanding. As I have

reduced real estate and bonds to near 0%, I have been replacing the

difference with hard assets and commodities which can benefit from inflation.

My stock mix has changed to be overweight energy and gold, plus other

commodities. The hard asset segment which had been as high as 30% of my

total portfolio in mid-2005, is now at around 16% as I took profits on energy

stocks in October and November. I will increase the weighting again if oil

pulls back to $45 or gold pulls back to $450 / ounce.

Equities / Stocks:

Stocks rotate by cap size along with the economic cycle. Historically, the

rotation begins with Small Caps at economic recovery (more nimble) and moves

to Large Caps (better global exposure and able to acquire small caps as the

business cycle generates cash flow). There is also a rotation in terms of

risk, from Growth at the beginning of an expansion, to Value at the beginningof a contraction. Stocks can be lumped by industry or sector into these

groups of value vs. growth and small vs. large cap, to assist with the

selection process.

When the economy does turn to a Bernanke engineered recession in mid 2006,

large cap value (Defensive) is called for at that point. Individual stocks

can be purchased, if you like picking stocks, or an index can be used. A

Large Cap Value screen using a minimum 2% annual dividend, minimum $20B cap

size, High ROE, Low Cash Flow multiple and Low Relative Strength (to capture

out-of-favor stocks) reveals some of the following stocks: Diageo (DEO),

Annheuser-Busch (AB, note Warren Buffet is accumulating this company), Exxon

(XOM), Johnson & Johnson (JNJ), Coca-Cola (KO), Merck (MRK), Altria (MO),

Wyeth, Conoco-Philips (COP), Pfizer (PFE), Dow Chemical (DOW), Dupont (DD),

and Verizon (VZ). This list looks a lot like my list from the last two

years, as large caps have remained out of favor since 2000 and now sport

lower P/E ratios than small caps, a rare event. There are several

established and highly regarded mutual funds covering these same stocks:

several good and diverse funds are: Vanguard Value (VIVAX, 6.31%), Dodge and

Cox (DODGX, 9.37%), Clipper (CFIMX, -0.3%), American Funds Washington Mutual

(WSHFX, 3.50%), and Oakmark (OAKMX, -1.7%). We can now use Exchange Trade

Funds (ETFs) to select sectors. A good ETF for large cap value, based on its

low annual expenses and large cross-section is: Russell Value 1000 (IWD,

6.64%).

We should continue to keep a cross section of small caps as my experience in

2004 and 2005 showed. Since small caps are hard to pick, unless you know

something about a company based on personal experience, it is good to usemutual funds or ETFs for small caps. As mentioned, two good ones (according

to Morningstar) that I own are Neuberger Genesis (NBGEX, 15.77%) and Fidelity

Low Price (FLPSX, 6.72%). There are several others that can be researched by

using Morningstar. Look for low volatility (beta) and high relative return.

Again, we now have an index ETF to help us in this category. I suggest:

Russell Small Cap 2000 (IWM, 5.20%). There are also Value and Growth only

versions of this Russell indexed ETF series.


13/18

Emerging Markets: This is a stock (and bond) theme that should play a large

role in any portfolio (5-10% of total). Emerging markets are the source of

future long term growth in the world economy. They provide a good hedge

against dollar weakness, and will increasingly provide a hedge against the

domestic economy (as Asia, for example, becomes a net consumer of products).

The best way to play the Emerging Markets is with managed funds. There are

several closed ends and ETFs in this segment. Templeton Dragon (TDF, 20.9%),

invests in China/Hong Kong, and is a fund I have owned since 1996 but traded

in for the broader market EMF in late 2005. Emerging Markets Fund (EMF,

31.65%) has a broader EM scope and provides exposure to East Europe and

Russia. We also now have the option of (EEM, 32.62%) which would have been a

very good choice. It is the Ishares ETF for emerging markets. (TEI, -

4.76%) is a closed end bond version of the Emerging Market funds, but did

poorly in 2005 due to the strengthening USD. Pimco also offers a good

emerging markets bond mutual fund (PAEMX, 7.97%). There is also a Fidelity

bond fund for foreign emerging stock markets, with a (FNMIX, 10.65%) ticker.

High Beta / high return stocks: Another stock category for the long term is

Biotech. If you look at investing themes that will do well over time, the

first thing to consider is the sectors that are driven by basic human needs.

People probably perceive health care as number three among necessities. Oneand two are food and shelter. But these are both commodities and could be

great investments over the near term, in an inflationary environment. Both

categories tend to be good defensive sectors going into a period of inflation

or a recession as was demonstrated by these sectors the past the 70s and

2000-02. Water is another good, defensive, basic needs theme. There is now

a Water ETF with ticker (PHO).

As dynamic as they are at the end of a recession, Biotechs and small tech

stocks can be hazardous to the investors health at the end of a cycle. They

are extremely volatile and subject to investor emotion. Maybe only one of

ten biotech companies will actually produce a viable medicine. No one, not

even the founders of the biotech, knows what the successful compounds will

be. The Biotechs were flat in 2004 and have had small to very good gains in

2005, and have fared much better than large cap pharmas, which have had price

declines due to patent expiration and litigation. This may be a good entry

point, though biotechs are not really cheap as in 2002 for example. A good

biotech ETF that owns many companies and is capitalization weighted (and

includes profitable Amgen, Genentech and Biogen) is either Ishares (IBB,

2.44%) or HOLDRS (BBH, 31.29%). The difference in the 2005 return between

these two similarly structured ETFs shows the degree to which active stock

picking matters in high beta funds.

At some point in time, after the market has gone through the multi-year Bear

phase, small cap, high beta technology stocks will again be interesting, as

they were in the mid to late 1990s (peaking on March 10, 2000). Until then,

I will stay away.

The Hedge: Better portfolio return is achieved by diversifying as measured

by a low (less than 1.0) or negative beta: when some stocks go down, others

go up. A negative beta will occur when a stock moves in the opposite

direction of the benchmark, usually the S&P500. This is also called

covariance by statisticians. A low beta stock, less than 1.0, is also

useful to mute the ups and downs of a portfolio. (The approach, by the way,

is called Modern Portfolio Theory or MPT, though I dont know how modern as

it first was documented in the 1950s by Harry Markowitz). As statistical

research and years of experience have shown, a small dose of hedging, say 10%


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of a portfolios total value, can reduce risk (volatility) without

significantly reducing return. In 2005 I used David Tices (BEARX, 2.02%)

fund to provide a little covariance. This fund is supposedly a mirror image

of the S&P500. I have not found that to be the case. He hedged his hedge

fund in gold, and poorly at that, and BEARX showed a greater loss than the

gain of the S&P. His gold hedge should have improved that performance, as

gold has done well this year. So, I sold my BEARX in mid-February and

decided to use options and shorts to achieve my hedge, along with ownership

in the Vanguard Gold and Precious Metals (VGPMX, 43.79%) fund (more on gold

stocks later).

I added stock options to my portfolio starting in the mid-year of 2004. I

continue using both option contracts and shorts to provide insurance for my

portfolio. In 2005, I used a combination of Way-out-of-the-money (WOOTM)

put contracts on the NASDAQ 100 (QQQQ) with January 2006 expiry, to provide

portfolio insurance. I bought these contracts in February and sold (closed

them out) in April at the bottom of a market decline, for a nice profit of

50%. Because these put contracts were intended for insurance, not for

profit, I bought more after a small market rise a few weeks later.

Fortunately for my portfolio, but unfortunate for the contracts, they

proceeded on their march towards zero. But during this period, expectingmore of the market bounce, I also bought some DVY (Dow Value ETF) December

call contracts, and sold them three weeks later for another 50% profit. So,

with the two profitable option transactions, I had paid for a good portion of

my annual portfolio insurance premium. At the end of this year, I had

realized significant capital gains on my profitable trades on stocks in my

taxable accounts (I try very hard not to trade my taxable accounts to

minimize taxes), but could offset that by my losses on my options contracts.

This meant my net capital gain for tax purposes was reduced by 50%. And, if

you have more capital losses than gains from your insurance program, and keep

your total investing losses less than $3000 per year, you can deduct all of

them from your income taxes. Trading expenses (which are amazingly low now

on options) can also be deducted. The US government will help pay for your

portfolio insurance.

Bonds:

Short term and inflation-protected bonds (Treasury Inflation Protected

Securities called TIPS) are called for with rates continuing to head up in

2006. Note: I said the same thing in 2004 and 2005 regarding rates and was

wrong on long term, but right on short term rates (like everyone else,

including Bill Gross). With real interest rates (interest return minus

inflation) reduced to negative levels in 2004, the rebound in short term

interest rates were offset by increases in inflation. Since TIPS are real

rate instruments, with a guarantee of a nominal market return over CPI

inflation, the TIPS did not do well in 2005, even compared to a simple money

market account. Vanguard provides the low cost TIPS fund, (VIPSX, 2.59%).

Longer term bonds (over 3 years) should be avoided for the immediate future,

though, if 10 year Treasury bonds make a move to 5.5%, it would be a good bet

to buy those, as the next move in interest rates would likely be down. But

my bet is that inflation due to commodities and the eventual devaluation of

the USD is structural and baked-in. Inflation always is poison for long

bonds (10 or more years). Because the economy is likely to weaken, high

yield or junk bonds should also be avoided. They are still at historical low

spreads over safe Treasuries, less than 2.5%, as has been the case for over

18 months. A good time to own junk bonds is when the spread is over 8%,


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typically during a recession. Other than short term Treasury and TIPS

options there are other interesting bond possibilities. Emerging market

bonds will take advantage of a weakening USA dollar and provide currency plus

market returns.

Real Estate:

Real estate has been good ballast in a portfolio. It has low correlation to

the stock market, but a high inverse correlation to the direction of interest

rates. Real Estate Investment Trusts (REITs) are the best way for the

average investor to participate in the real estate asset class. It is also

possible to own individual properties, but management of those properties

requires time and effort. Also, it is hard to gain adequate diversity by

owning individual real estate. A minimum of 15-20 properties in several

geographic locations and different property classes (e.g. apartments, shops,

offices) would be required to become truly diverse.

Because of the so-called real estate bubble in the housing market and the

coincident runup in the price of the average REIT, it is not a good time to

own REITs. REITs were yielding over 8% in the late 1990s, when the asset

class was out of favor. Subsequent price increases in REIT stocks (and theirunderlying real estate) has reduced the return to below 3.5%, less than many

dividend paying industrial equities that often pay out less than 35% of their

cash flow. REITs, on the other hand, must pay out 95% of cash flow according

to the tax code. If the air comes out of the housing market, as I suspect

will be the case, REIT prices will decline in sympathy. That combined with

higher interest rates which discourage home ownership by raising mortgage

payments, will allow leases and rents to increase. That will set the stage

for higher REIT yields over the next 2-3 years and a chance to re-aquire

REITs at a better price. Fidelity (FRESX, 14.9% in 05) and Vanguard (VGSIX,

11.89%) both have good REIT funds, as does Cohen-Steers Realty (CSRSX,

14.88%). The Cohen Steers REIT fund has a sister ETF fund that can be traded

intra-day (ICF, 14.57%). REITs have returned well above average for the

fourth year in a row. This will not continue. A price decline of 30% would

return REIT prices to their long term total return trend line (12% annual)

and increase yields to back over 5%.

Fidelity has just introduced an international REIT called (FIREX, 14.94% in

2005). This might be a good place to pick up strong real estate returns the

next few years while hiding from a declining dollar.

Hard Assets / Commodities:

I have been promoting Oil as an investment now since 2002 (actually, I made

my first oil investment in 1997 with Freeport-McMoran with its 14% dividend,

but was early on that one. I sold for a small loss when the dividend was cut

to 4% during the oil price decline of 1998). In last years letter, I pushed

the oil theme harder than ever. If you went along with the recommendation,you are today very happy. It turned out to be a solid bet, with average

appreciation over 40%, depending on whether it was drilling equipment,

producers, natural gas or integrated oil stocks that were purchased. This

will continue to be a good market sector, all though there may be a short

term pull back if the market sees recession. That will imply lower demand,

and hence a lower price for oil. However, the long term trend favors much

higher prices, so a pullback will create another buying opportunity.


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Matt Simmons is an industry expert who wrote a book last year called

Twilight in the Desert. He recently stated in a Barrons interview

(January 2 edition):

I've placed a $5,000 bet (with a NY Times reporter) that oil prices

will average $200 a barrel in 2010. I don't have any idea where oil

prices are headed (next week) but they could easily be above $200 a

barrel. At $65 a barrel, or 10 cents a cup, we are still grossly under-

pricing oil, which is why it (high prices) doesn't have any impact on

demand. As the markets get tighter, sooner or later we are going to

have shortages. And the two times we have ever had shortages in North

America within 90 days, the price of oil went up threefold.

T. Boone Pickens is also public with similar theses regarding the short term

(down) and long term (up) price of oil, as is industry consultant Tom Petrie

and consultant Robert Wulff of McDep Associates (www.mcdep.com). Energy

should be a large portion of any portfolio for the next 10 years or more,

during the time Chinese and Asian economic expansion puts supply pressure on

marginal production.

Also last year, I began suggesting gold for the first time. This also turnedinto a good bet and the gold thesis continues to look good. Gold bottomed at

$250/ounce in 2001. Since then, it has doubled to over $500. As reported

last year, gold has been the Anti-dollar since 1971, when the USA (and by

extension, any central bank with currency linked to the dollar or otherwise

using fiat currency, e.g. the Euro) went off the gold standard and onto a

paper based standard (the USD). Paper-based standards are backed only by the

government of the issuing country and its economic prospects. If those

prospects decline, so will the currency. When financial assets and the

dollar are strong, gold is weak. When financial assets backing an economy

and its associated currency decline, as during a period of debt-induced

inflation, gold will strengthen.

The dollar became the worlds reserve currency after 1971 at the end of the

gold standard from this point on, gold and the dollar have moved in opposite

directions. From 1982 onward, as the Fed Funds interest rates decreased from

near 20% to just a little over 1%, the dollar strengthened. The dollar was

strengthened by investors conviction that the dollar was safe. The

relatively high interest rates in the USA from the 1980s provided a further

attraction. The more money flowed into zero risk USA Treasury bonds and

bills, the stronger became the dollar, since other currencies were in effect

traded for dollar denominated Treasuries. As the USA interest rates declined

over a 20 year period, buying long term US bonds and bills became a very wise

investment. Bonds appreciate in value as interest rates decline. This

created a virtuous cycle, lower rates attracted more foreign currency, and

more foreign currency flowing to America drove down interest rates. But the

bottom is now in at 1.25% Fed Funds rate in 2004. It has now increased by 3%

and sits at 4.25%. As the interest rate cycle is long, we can expect gradualincreases in inflation and interest rates for another 10-15 years.

Last year I wrote: Even if the worst case does not come about (a dollar

collapse), it is likely that the Chinese must de-link currencies in the next

2-3 years. Our problems are becoming their problems. Our devaluing currency

is expanding their money supply at a time when the Chinese government would

like to throttle back to avoid hyper-inflation, over-investment and

ultimately an economic crash. When China de-links, it will cause their

exports to cost more in USD terms, and we will undergo accelerating


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inflation. The end result of these concerns is the need to own either

commodities (in the form of mining, energy or other natural resource

companies), and rare metals (gold, silver, platinum, etc) in certificate or

in fact.

About this paragraph, I will not change a thing. In fact, the Chinese did

de-link in 2005 for the first time. They have elected to link to a currency

basket that they will not define. It is likely they intend to gradually

change the mix of currencies away from the USA dollar. They will gradually

decrease their dependence on American assets. Because there are no other

really good fiat currency alternatives, I am betting they will be adding

more and more precious metals to that reserve basket. What does this mean

for us as investors? Vanguard Gold and Precious Metals (VGPMX, 43.79%) was

recommended last year in this space as a low cost way to get the needed

exposure to the precious metals that China will seek as part of its currency

basket. VGPMX has a current 3.5% yield. It returned 43.79% in 2005, well

ahead of actual gold. There is operational leverage in the mining stocks

that comprise VGPMX. The fund manager is also free to move between countries

for exchange rate advantage and types of precious metals depending on what is

most undervalued. Individual mining stocks like AU (37.9%), or Newmont

Mining (NEM, 21.4%), or the gold ETF (GLD, 17.76%) are also available toprovide a hedge against inflation.

As for Energy stocks, again, I wouldnt change anything, other than to

recommend more natural gas and producer stocks, but not until we have seen a

price pullback under $50 / barrel. The large cap integrateds have not done

well. Will they in 2006? At some point, the market will recognize their

value. The integrated energy companies are disadvantaged in that much of

their oil reserves are in countries where the government receives a large

portion of the profits resulting from increasing prices over the production

cost. The best integrated companies own large domestic natural gas reserves

and refining capacity where margins are high. Most trade at less than 10x

earnings. Large cap integrated energy companies like Exxon (XOM), Chevron

(CVX) and British Petro (BP) may be the most exposed to the negatives of this

segment while Conoco (COP) which just bought natural gas producer Burlington

Resources is a good bet. There are several diversified ETFs in this sector.

(IYE, 34.67%) is a good domestic and diverse choice with a 35.5% return in

2004, and more to come. (IXC, 29.47%), up over 35% in 2004, provides more

international exposure, and possible benefit from the resulting currency

trade. (OIH, 62%) and up over 56% in 2004 is focused on only the energy

equipment manufacturers. This provides a higher beta in this group, which

means higher return as long as energy does well. There are also many energy

mutual funds including the Fidelity Natural Resources, (FNARX up 40.94%) that

also provides some mining exposure and Vanguard Energy (VGENX up 40.05%).

In early 2005, I added to my positions in oil and gas producers that trade as

trusts. The best trusts are the Canadian Royalty trusts that are given

special tax treatment to help provide income to retirees. I currently ownPetrofund (PTF) and Provident (PVX) which have done very well in 2005 while

providing a terrific dividend payout over 12%. The high dividends pay out

makes them best for tax advantaged accounts like IRA or 401K. They will

continue to perform well as their reserves gain in value.

Cash:


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Documents

Brian McMorris - New Year Financial Outlook - 2006